APPLIED TAXATION OF TRUSTS EXTRACT CPA Australia Ltd 2015 1
CONTENTS Course overview 1 Learning objectives 1 Knowledge assessment 1 Symbols 1 1. The basic features of a trust 3 1.1 Introduction 3 1.2 How a trust is established 3 1.3 What types of trusts can be used? 12 1.4 Why is the trust deed so important? 16 1.5 Personal liability of directors 22 2. Taxation of trust income 24 2.1 Introduction 24 2.2 How is a trust s taxable income calculated? 27 2.3 When will a beneficiary be presently entitled to a share of trust income? 29 2.4 How do you ensure that a beneficiary pays tax instead of the trustee? 37 2.5 How does a trustee make a beneficiary specifically entitled to a capital gain or franked distribution? 41 2.6 How to ensure that double taxation does not apply under Division 6 where a beneficiary has been made specifically entitled to a capital gain and/or franked distribution 47 2.7 What special tax rates apply to particular types of beneficiaries? 49 3. Corporate beneficiaries 54 3.1 Introduction 54 3.2 When will an unpaid present entitlement (UPE) owed to a private company beneficiary be regarded as a deemed dividend? 55 3.3 Small business concessions significant individual 62 3.4 Small business concessions dilution of benefit 65 3.5 Asset protection 69 4. Family trust elections 72 4.1 Introduction 72 4.2 Discretionary trust with losses 72 4.3 Unit trust with losses, and the need to make an election 81 4.4 Trust owning shares in company with losses 84 4.5 Family group and family trust distributions tax 86 4.6 Completion of loss schedule 90 4.7 45 day rule and need to make election 91 4.8 Trustee beneficiary reporting rules 95 4.9 Extension of TFN reporting and withholding rules to closely held trusts 96 5. Capital gains tax 99 5.1 Introduction 99 5.2 CGT event E1 Creating a trust over a CGT asset 99 5.3 CGT event E2 Transferring an asset to an existing trust 101 5.4 CGT event E3 Converting a trust to a unit trust 102 2 CPA Australia Ltd 2015
5.5 CGT event E4 Capital payment for trust interest 103 5.6 CGT event E5 Beneficiary becomes entitled to trust asset 104 5.7 CGT event E6 Disposal to beneficiary to end income right 106 5.8 CGT event E7 Disposal to beneficiary to end capital interest 107 5.9 CGT event E8 Disposal by beneficiary of capital interest 108 5.10 CGT event E9 Creating a trust over future property 109 5.11 Access to CGT general discount by a trust 109 5.12 The small business concessions Unit trust 113 5.13 The small business concessions Partnership of discretionary trusts 115 6. Testamentary trusts 117 6.1 Introduction 117 6.2 Issues to consider in creating a testamentary trust 117 6.3 Income tax advantages of testamentary trusts 119 6.4 Trustee can determine who is assessed on a capital gain 120 7. Refinancing 122 7.1 Introduction 122 7.2 Repaying borrowed funds 122 7.3 Deceased estate and payment to satisfy obligation 123 7.4 Unit trust refunding capital, refinancing unpaid present entitlement 124 7.5 Repayment of amount of unpaid present entitlement converted to loan 126 7.6 Unrealised gains 126 7.7 Family trust and money used for other than income producing purposes 127 7.8 Non-fixed trust apportionment of interest expense 128 8. Resettlements 130 8.1 Introduction 130 CPA Australia Ltd 2015 3
1. THE BASIC FEATURES OF A TRUST 1.1 INTRODUCTION Trusts are a commonly used business and investment structure in Australia. Prior to discussing the key issues arising from the tax treatment of trusts it is, however, prudent to revisit trust law principles to understand the basic features of a trust. Accordingly, this chapter discusses the following fundamental elements that should be considered in setting up a trust structure: The steps required to establish a trust including the various roles played by key stakeholders including settlors, appointors, trustees and beneficiaries. The various types of trusts that can be created and the different tax planning implications that arise if a discretionary or fixed trust is used. The key issues that should be addressed in any trust deed executed on the creation of a trust. The circumstances in which the directors of a corporate trustee will be personally liable for an action by creditors. 1.2 HOW A TRUST IS ESTABLISHED 1.2.1 Background CASE STUDY Andrew and Patricia Reeves approach you as their accountant to recommend an investment structure for them. They have been married for 10 years and have one child aged 11 who is at school. They currently have some $200,000 invested in a bank account (in joint names) and have been paying tax on the interest income derived at their marginal tax rates. They are considering purchasing a portfolio of shares. Currently Andrew is a house husband, and Patricia works as an advertising executive and earns approximately $130,000 per annum. Patricia is about to be appointed a director in the company that she works for. Some friends tell them that they should be using a family trust and they want to understand how one is set up. 1.2.2 Analysis The term trust is not defined under either section 6(1) of the Income Tax Assessment Act 1936 (ITAA36) or section 995-1 of the Income Tax Assessment Act 1997 (ITAA97). Instead, its meaning is determined according to common law and equitable principles. Applying these principles, a trust is not a separate legal entity; rather, it should be characterised as a documented relationship, subject to trust law. The required document is the trust deed and the relationship exists between the person(s) who created the trust by giving the trust property, the person(s) who legally operate(s) the trust property and person(s) who may equitably benefit from the trust by receiving income and/or capital distributions. Accordingly, it is a key feature of a trust that there is a distinction between the legal ownership of property which is held by a trustee and equitable ownership of property which will be held by a beneficiary. There are two main ways that a trust deed can be established other than by the creation of a testamentary trust (which is discussed in more detail in Chapter 6). The whole process can be 4 CPA Australia Ltd 2015
managed by a lawyer, or you can purchase a standard trust deed and instruct a lawyer or a shelf company firm to modify it to suit your needs. The actual mechanics of setting up a trust are reasonably simple: Decide what type of trust will be established (e.g. discretionary or fixed trust). Decide who will be the beneficiaries. Decide who will be the settlor (if a discretionary trust or, in some cases, a unit trust). Decide whether there will be an appointor and, if so, who it will be. Decide who will be the trustee. Have the trust deed drafted. Have the settlor give the settled sum to the trustee or have the unit holders subscribe for their units. Have the trust deed executed. Have the trust deed stamped (if necessary). If a corporate trustee is to be used, incorporating the trustee company can be added to the list. Both advisers and clients should carefully review the clauses of the trust deed as those terms potentially affect every transaction that the trustee engages in on behalf of the beneficiaries. This has become particularly critical following the High Court decision in Commissioner of Taxation v Bamford; Bamford v Commissioner of Taxation (2010) HCA 10 where it was held that the phrase income of the trust estate takes its meaning under trust law rather than the taxation law. Accordingly, where the trust deed defines the term income that will in practice be the definition that will be applied in determining how beneficiaries (and/or trustees) are ultimately taxed on the trust s taxable income under Division 6 of the ITAA36. As discussed below, it is essential that each trust deed now be closely reviewed to determine whether the term income of the trust estate has been defined under the trust deed, and if so the terms of the specific definition of trust income that has been adopted under that deed. In addition, it should be noted that there is a broad array of different definitions of income in trust deeds which have been progressively prepared over time which may have varying tax impacts in terms of the way in which beneficiaries (or trustees) are assessed on trust net taxable income. Furthermore, it is also essential that a trust deed contains a clause allowing a trustee of a discretionary trust to stream capital gains and franked distributions on or after 1 July 2010 if that trustee wishes to direct such gains and dividends to specific beneficiaries. Finally, it is critical to read the trust deed to determine when a trustee of a discretionary trust must make and document a resolution concerning the distribution of the income of the trust estate as the Australian Taxation Office (ATO) now require that such resolutions be made by the time specified in the trust deed. In practice, the overwhelming bulk of trust deeds will require such a resolution to be made by year-end at 30 June meaning that the trustee must determine how trust income for a particular year is to be distributed by that year-end date. These issues are dealt with more extensively below, especially in Chapter 2 concerning the taxation of trust income which discusses, amongst other things, complex provisions concerning the streaming of capital gains and franked distributions by trustees of discretionary trusts and the removal of administrative concessions by the ATO allowing trustee resolutions to be made after year-end. In setting up a trust it is also crucially important that you understand the roles that are played by the settlor, the appointor, the trustee and the beneficiaries as detailed below. The settlor The settlor of a trust is the person who establishes the trust. A trust is normally established by the settlor giving property, such as money, to be held on trust for the beneficiaries. CPA Australia Ltd 2015 5
The property should be freely given with the intent that it be held for the benefit of the beneficiaries. The property should also be valuable, with $100 and upwards generally being seen as a reasonable amount. A settlor cannot benefit from a trust that they establish, and if for some reason they do, the trust can be void. This means that a settlor should not be a beneficiary of the trust. If the settlor is reimbursed for the gift they make, perhaps by an accountant being the settlor and billing their client for the gift, the Courts can consider that the client is the real settlor. This means that if the trust was established for the benefit of the client, it can be void. TAX TRAP It will be acceptable for a tax adviser, accountant or lawyer to charge a fee in connection with the establishment of a trust. What will not be acceptable is to have a line on the bill such as: Disbursement settled sum $100. A settlor will exist for every discretionary trust, but is not typically required for a unit trust, where the initial sum subscribed by the unit holders can form the basis for the establishment of the trust. The appointor A trust may include someone in the role of an appointor. An appointor has the power to appoint and remove a trustee. An appointor can be one person acting individually, or more than one person acting jointly. Being an appointor, if you are also a beneficiary, is quite a position of power as you have ultimate control over the trustee, who in turn controls who benefits from the trust, and how the trust is operated. For this reason, care should be taken when selecting an appointor. Moreover, the trust deed should expressly include a provision to ensure that there is a mechanism for the replacement of an appointor should the appointor die or wish to stand down from the role. As is the case with other facets of a trust s operation it is crucial to correctly apply the terms of the trust deed to determine the specific entities which will be regarded as the appointor, trustee and beneficiary under a trust. For example, in the recent High Court decision in Montevento Holdings Pty Ltd v Scaffidi (2012) HCA 48 a clause in the trust deed provided that where an individual appointor was a potential beneficiary under the trust that person could not also be the trustee of that trust. In this case it was contended by a rival potential beneficiary that a company could not be appointed as the corporate trustee of the trust as the individual appointor was the sole shareholder and director of that corporate trustee whilst also being a potential beneficiary under that trust. However, the High Court subsequently found that the above clause in the trust deed did not prevent the appointment of the company as the corporate trustee as it was a separate legal entity for the purposes of the trust deed even though its sole shareholder was a potential beneficiary of the trust. Asset protection Having an appointor also has potential advantages from an asset protection viewpoint. In the past, the power to appoint a trustee has been used to prevent assets from being accessible in the case of a property settlement in the Family Court (see Ascot Investments Pty Ltd v. Harper (1981) HCA 1 where the High Court determined that the Family Court had no jurisdiction over persons who were not party to a marriage.) This case led to planning opportunities where more than one person would act in the role of appointor, for instance a wife and her friend, with any decision to appoint or remove a trustee having to be made jointly. If the marriage was breaking down, the wife and her friend could then jointly agree to appoint the friend as the trustee. When the property settlement between husband and 6 CPA Australia Ltd 2015
wife came before the Family Court to be finalised, the court would be unable to direct the friend to distribute the trust s assets as trustee in accordance with its instructions, as the friend is not a party to the marriage. In addition, although the Family Court could direct the wife to vote to make herself trustee, she had only one vote and could not affect who was the trustee without her friend s consent as appointor. As a result of changes to the Family Law Act (1975) in December 2004, and particularly the addition of section 90AE to that Act, it is now likely that the Family Court will have the power to direct how third parties should act in such circumstances. Section 90AE(2) empowers the Family Court to make an order that: (a) directs a third party to do a thing in relation to the property of a party to the marriage; or (b) alters the rights, liabilities or property interests of a third party in relation to the marriage. The Court can, however, only make such an order under subsections 90AE(3) and 90AE(4) if: making the order is reasonably necessary, or is reasonably appropriate and adapted, to effect a division of property between the parties to the marriage; if the order concerns a debt of a party to the marriage, it is not foreseeable at the time that the order is made that to make the order would result in the debt not being paid in full; the third party has been accorded procedural fairness; in all the circumstances, it is just and equitable to make the order; and the Court has taken into account: a) the taxation effect (if any) of the order on the parties to the marriage and on the third party; b) the social security effect (if any) of the order on the parties to the marriage; c) the administrative costs of the third party in relation to the order; d) the capacity of a party to the marriage to repay a debt after the order is made if the order concerns a debt of a party to the marriage; e) the economic, legal or other capacity of the third party to comply with the order; f) any other matters raised by the third party; and g) any other matter that the Court considers relevant. You should consider seeking professional legal advice over issues involving what may or may not work in the case of a Family Court action. WARNING The limitations of using a discretionary trust to shelter property on a matrimonial dispute was also recently considered in the High Court case of Spry v Kennon (2008) HCA 56. In this case a wife contended that certain assets held in discretionary trusts should be included in the pool of assets which should have been divided equally between the spouses on a matrimonial settlement as those interests held by the spouses were property of the marriage. Broadly, it was held that a discretionary beneficiary s right to due administration of the trust and the right to be considered as an object (i.e. potential beneficiary) of the trust, and the trustee s power to apply the income or assets of the trust, were property of the marriage (even though it may be difficult to put a value on such rights). Accordingly, the total value of the trust assets was included in the pool of property divided between the spouses for family law purposes. A subsequent decision of the Full Court of the Family Court held that the wife in this case could enforce such a judgment for the payment of the outstanding balance of her share of the property of the marriage (see Stephens v Stephens (2009) FamCAFC 240 which used the pseudonym of Stephens in lieu of Spry to provide some level of confidentiality to the proceedings). This latter CPA Australia Ltd 2015 7
decision illustrates the Family Court s willingness to consider a spouse s interest as a discretionary object of a trust as being property of the parties to the marriage. Whilst Spry s case may be distinguished on its own facts it suggests that a court may be prepared to look behind a discretionary trust to attribute particular trust property to particular beneficiaries on a matrimonial dispute. However, it should be noted that a similar issue was recently considered by the Family Court in Harris v Harris (2011) FamCAFC 245 which also dealt with the issue of whether the assets of the trust should be treated as part of the husband s property for the purposes of a property settlement dispute. In particular, it considered whether the husband indirectly controlled the trust as his mother was the appointor of the relevant trust. The Family Court held in the Harris case that the husband did not indirectly control the trust in that it could not be proven that his mother as appointor was a puppet who would act in accordance with his instructions. Hence, the court found that the trust and its assets were not property of the marriage. The impact of the Harris case is that the scope of the Spry case may not be as wide as initially thought. However, it should be noted that a contrary conclusion could have been reached if there had been clear evidence produced to prove that the husband did indirectly control the trust. The case also highlights the tension between wishing to indirectly control a trust and the need for asset protection, and that these conflicting priorities must be considered when setting up a discretionary trust structure. Many business owners in the SME sector have also used discretionary trusts as an asset protection vehicle in case of bankruptcy. However, in the same way that the Family Court might now be able to direct parties to a marriage on how to deal with trust assets if they are the trustees or have the power to appoint the trustee, the same might occur if a bankrupt were in the position to determine who is the trustee of a trust. This would occur if the bankrupt were the appointor of the trust and the appointor power passed to their trustee in bankruptcy. In general, the Federal Court takes the view that the power of appointment of a trustee of a trust cannot be exercised by the trustee in bankruptcy, or that if the trustee in bankruptcy did exercise the power and then direct value in the trust to be distributed to themselves for the benefit of their creditors, they would be acting in breach of trust. While this is the prevailing view, it would be worthwhile having a clause in the trust deed that stops someone having the power of appointment if they become bankrupt, or alternatively using joint appointors as noted above. WARNING The strategy of using a trust to provide for asset protection in the case of bankruptcy is a contentious issue. You should review the current position for trusts and bankruptcy prior to providing advice on this issue. Further information can be obtained from the website of the Australian Financial Security Authority at: <www.afsa.gov.au> or the Attorney General s website at: <www.ag.gov.au>. WARNING A Federal Court decision in one of the Richstar cases adds further doubt to the level of asset protection provided by a discretionary trust in recovery proceedings. (Australian Securities and Investments Commission in the matter of Richstar Enterprises Pty Limited (No. 6) (2006) FCA 814.) 8 CPA Australia Ltd 2015
WARNING (continued) This case concerned an application by the Australian Securities and Investments Commission (ASIC) to have a receiver appointed to recover assets held in the defendant s discretionary trust on the basis that their contingent interests in such property constituted property under the Corporations Act (2001). French J held that the trust in issue was controlled by a trustee which was the alter ego of the defendant beneficiaries because it was as good as certain that those beneficiaries would receive the benefits of the trust as they effectively controlled the trustee. Whilst the scope of the Richstar case may be confined to its own particular circumstances, it nonetheless was a departure from long standing trust law that a potential beneficiary does not have an interest in trust property. TAX TRAP If one of your purposes in transferring an asset to a trust is to put it out of reach of creditors you should consider the provisions of sections 120 and 121 of the Bankruptcy Act (1966). Broadly, section 120 provides that a transfer of property by a person who later becomes bankrupt may become void against the trustee in bankruptcy if the transfer takes place in the 5 years before the commencement of bankruptcy and the transfer occurred for less than market value. A lesser period may apply where it can be established that the transferor was solvent at the time of transfer. Under section 121 a transfer will also be void against the trustee in bankruptcy where the property would have been otherwise available to creditors, and the main purpose of the transfer was to prevent it being divided amongst the transferor s creditors. The trustee The trustee of a trust can be a natural person, more than one person, or a company. Broadly, a trustee can also be a beneficiary of a trust provided they are not the sole beneficiary (see DKLR Holdings Co (No.2) Pty Ltd v Commissioner of Stamp Duties (NSW) (1982) 149 CLR 431). TAX TRAP It should be noted that many trust deeds prepared in New South Wales will prevent a trustee from being a beneficiary of a trust. Such a clause may be inserted into a trust deed as the stamp duty exemption otherwise available under section 54(3) of the Duties Act (1997) upon a change in trustee will not be available if a new or continuing trustee can benefit under the trust as a beneficiary. Hence, care should be taken in reviewing the trust deed (especially those prepared in New South Wales) taking into account relevant state legislation. The trustee is responsible for the day-to-day management of the trust, and their obligations and powers are outlined in the trust deed. Most trust deeds would give a trustee the power to deal with the property of the trust, make investments and carry on a business. However, to the extent the trustee acts outside the powers and restrictions set out in the trust deed, those actions can be rescinded and the trustee may be personally liable for any loss. Where this occurs, the trustee will be acting ultra vires and in breach of the trust. Thus, a trustee should take care to ensure that any action they undertake is permitted under the trust deed. Conversely, a trustee is not generally liable for actions that they take on behalf of the trust which are allowed under the trust deed. CPA Australia Ltd 2015 9